2012-FEB-05
Every once in a while a bubble forms in a market. Bubbles can occur in any market, whether stocks, commodities, real estate or as we know from history, even tulip bulbs.Market bubbles are, as the name implies, unsustainable. They are manifest by inflated prices that go up and up to achieve unthinkable levels for a while, and in some cases, for a very long while. But like their soap-bubble counterparts, market bubbles clearly lack durability. They can pop at any time. So inevitably, the bubble pops, with the unfailing result that prices thereafter quickly drop back to earth.
In essence, bubbles are nothing more than an emotional frenzy in which prices climb to unheard of levels, until the market attains a shocking level of overvaluation. To achieve this outrageous situation in which price far exceeds an asset’s value, a bubble involves the near-universal acceptance of some delusive idea.
One notorious example is John Law’s scheme in 1716 promoting the virgin lands surrounding the Mississippi River, which was a ruse that swindled the entire French nation. The resulting Mississippi Bubble has forever been regarded as the apotheosis of market bubbles, but it shares with all bubbles one dominating characteristic.
Even though prices move far out-of-line with an asset’s fundamental value based on any prudent measure, people do not react as one would logically think. Instead of recognising a bubble for what it is, people instead tend to rationalise why prices are so high. They try to explain to themselves and others why prices are supposedly reasonable.
This attempt to rationalise what is illogical and abnormal is a unique characteristic of bubbles. But it is not too difficult to see why this foolhardy thinking happens. When you are living in a bubble, it is very hard to accept the reality that you are indeed in the midst of a bubble.
Thus, the inability to perceive foolhardy thinking is a result of most everyone saying, doing and thinking the same things. This mutual, identical action reinforces one's view to mistakenly believe that what they are thinking is correct and normal instead of what it really is, namely, the erroneous and illogical pervasive thinking that characterises a bubble.
As an example, today this rationalisation explains why US government debt cannot possibly be overvalued because [....]. Go ahead. Fill in the blank. We have heard the countless reasons why US government debt is supposedly a safe haven.
In short, while technology and other circumstances are constantly changing the world, the common denominator is that human nature never changes. Consequently, bubbles are possible because people are always willing to believe the unbelievable, such as the delusory thinking that one is buying a safe haven with the debt instruments of an over-leveraged government that has made far too many financial promises.
Only after it pops does the bubble become obvious. It is only then that the stark realisation dawns on people that they had been living in a bubble, and the serious questions get asked.
To take but one example from the 2000 stock market bubble, why would anyone have bought Cisco at $75 a share (which is more than four-times higher than its current price over a decade later) when it had a market cap more than 20-times annual sales and no earnings when properly accounting for the cost of employee stock options? But many people did buy it.
Law's scheme was based on the false premise that the lands of Mississippi were worth far more than they really were worth. Though false, this premise became widely accepted.
People bought into the bubble, inflating the stock price of his Mississippi Company. At the peak, price far exceeded value, but this reality was only recognised only after the bubble had popped.
Clearly gold is not in a bubble. It does not follow the pattern of bubbles. Gold is not widely owned today, which stands in stark contrast to what would be expected if it were in a bubble. More importantly, instead of gold owners trying to rationalise a high price, people who do not own gold are giving reasons not own it.
There is a bubble today, but it is not gold. It is the debt instruments of the US government and indeed, other governments that have also made far too many financial promises. Many of these promises will be broken and many debts repudiated, but most people do not understand or refuse to accept this reality. Ignoring prudent financial analysis and even the lessons of history, they still believe government debt is a safe haven.
